Investment outlook shaped by extraordinary economic and political environment

Global
economies should continue growing beyond the current year, helped by expansive
monetary policy and additional fiscal support. Corporate earnings and dividends
will benefit. We expect risky assets like shares and property to beat defensive
assets like cash and fixed interest over the next several years.

We now have
more cautious positioning in our multi-asset portfolios, although we are not
overly bearish. Now is the time for investors to have even greater focus on
quality and selected diversification. For our direct equity holdings, we are
looking for companies with a competitive edge within their respective
industries and are seeking opportunities in out-of-favour value stocks.

Elevated
valuations in certain segments and the likelihood that various events could
unsettle markets during 2020 encourage us to hold higher than usual cash levels
so we are ready to snap up bargains as they are offered by the market.
Corporate credit is an area of increasing concern, particularly as credit
spreads have tightened despite slowing earnings growth and rising debt. If
inflation modestly rises as we expect, long bond yields are likely to rise from
depressed levels.

Activity
is stabilising once more following the growth slump through 2019. Manufacturing
activity appears to be improving while steepening yield curves point to rising
confidence and the US/China trade truce promises at least a mild recovery in
trade. Consumption is assisted by jobs growth and low interest rates but may
moderate as employment markets tighten.

Few
signs point to a global recession in the near term. Yet it is unlikely that
global growth will soon get out of the slow lane. High debt levels, aging
populations, technological disruption and climate change each meaningfully
obstruct faster growth.

Fiscal
policy is supportive in China, Europe and Japan, but there is little impetus
for governments to lift spending by the degree required to bring about a
sharper upswing. Trade-exposed Germany remains committed to budget balance and
debt constraint despite being close to recession with the elevated risk that
job losses in the automotive sector could broaden to the wider economy.

China
growth slowing but more sustainable

China’s
economy is structurally slowing as it transitions away from credit fuelled
growth through infrastructure development and support for inefficient
state-owned enterprises toward more sustainably expanding consumption and
private enterprise. Firming manufacturing data indicate the worst of
the impact of US/China trade tensions is passing. The Government has lifted
infrastructure investment to further sustain positive momentum.

The
coronavirus outbreak will drag first quarter activity. The degree to which it
is deadly and contagious is not yet known. The coronavirus will interrupt
travel, accommodation and retail sales. Consumption growth had already slowed
before the outbreak in tandem with more subdued discretionary income growth,
household deleveraging and the hit to confidence from US/China tensions.
Authorities will respond rapidly with additional monetary and fiscal support to
meet growth targets for the full year. However, the structural shift towards a
services-based economy means the response is likely to be slower than in the
past. Overall growth this year is likely to be down on 2019.

Asset
prices are being distorted by highly accommodative monetary policy including
extremely low interest rates and bond purchases by central banks in the US,
Europe and Japan.

Only
in 2018, the US Federal Reserve and European Central Bank were reducing the
size of their balance sheets and the US Federal Reserve was in the middle of
raising interest rates toward normalised levels.

In
a significant about face, the US Federal Reserve cut rates by 25 basis points three
times last year. It also recommenced a bond buying program and guided to low
interest rates for an extended period. Central banks in Europe and Australia
were prompted to follow this path of renewed accommodation.

The
resultant fall in interest rates now sees the value of debt with sub-zero
yields, guaranteeing a loss to investors holding to maturity, reach USD 14
trillion internationally. Given

economic
conditions have not collapsed, investors have been encouraged to purchase
riskier assets like equities and credit. The volume of corporate debt,
particularly in the US, has expanded markedly while credit spreads have
narrowed. Investors have been enticed toward lower quality credit in search of
enhanced yield. Share prices have appreciated despite slower
economic growth and only mild earnings expansion.

Investors
should be aware of the increased financial vulnerabilities associated with the
present extraordinary monetary policy settings. Central banks have less
firepower to fight the next downturn. In the meantime, the debt cycle is likely
to last longer. Inefficient companies that would not otherwise have access to
debt markets are able to survive longer. There are likely to be terrible
collapses once interest rates climb once more, especially when coupled with a
downturn in demand.

Unappreciated
inflation especially in the US

The
prospects of gradually rising inflation are seemingly being ignored by
investors. The US labour market is tightening as robust jobs growth continues
while tougher immigration rules restrict workforce expansion. New tariffs are
disrupting supply chains. Technological change and globalisation have
suppressed inflation, but this will not last forever. In time, the innovations
we have witnessed in the last decade such as in robotics and artificial
intelligence will boost productivity and this will add strength to workers’
ability to push for higher wages.

Several
measures of US inflation are already above the 2% target, though the US Federal
Reserve’s preferred measure now reads 1.6%. Inflation expectations based on
financial instrument pricing is merely for inflation to average 1.7% over the
next five years. Realised inflation is likely to exceed this, encouraging the
yield curve to steepen in time.

CHART 1: US INFLATION

Source: St Louis Fed, AssureInvest

In
an election year, the US Federal Reserve will prefer to stay on the side lines.
With inflation shifting upwards and unemployment declining toward 3%, the US
Federal Reserve is likely to raise rates in early 2021. A rate rise in the
second half of this year is not impossible. Interest rate policy is set to
prompt market volatility. The market is expecting one 25 basis point cut this
year.

Geopolitical
risks

Geopolitical
power struggles exampled by recent tensions in the Middle East and between the
US and China threaten financial market stability.

Trade
uncertainty is likely to continue for several years and may even rise after the
US election. It is unlikely that trade war would bring about recession, but there
are implications for specific companies, industries and the relative
competitiveness of various countries. The “phase one” deal helps remove some
uncertainty by reducing tariffs on several Chinese goods in exchange for
increased purchases by China of US farm, energy and manufactured goods. However
key structural disagreements remain such as in relation to intellectual
property protections, forced technology transfers, currency management,
subsidies for Chinese companies and strategic rivalry.

Britain
has now left the European Union but there remains considerable uncertainty
about the implications for its own economy. Consumption and investment will
benefit as the confounding dilemmas arising from the 2016 Brexit referendum are
gradually resolved. Widespread moves of financial sector businesses to mainland
Europe do not appear to be occurring. It is most likely that the EU will be
constructive rather than punitive in its dealings with the UK and in the
establishment of new trading arrangements.

Elections
in US this year and Germany next year are likely to influence asset prices.
Populism continues to grow internationally as soft economic activity and rising
income inequality are fuelling the continued rise in populism as trust declines
in mainstream political parties. Several political movements encourage
isolationism and downplay the value of global institutions. High inequality
fuels support for policies that may slow short term growth such as wealth taxes
and increased social security and healthcare funding. The proportion of total
US wealth accounted for by the 1% most wealthy individuals is now 32%, up from
29% in 2006.

CHART
2: US WEALTH SHARE

Source:
US Federal Reserve Board

It
seems most likely the Democrats will maintain control of the US House of
Representatives while Republicans maintain control of the Senate. The markets
are likely to take a win by the current administration or a centrist Democrat
in their stride while victory by a left-leaning Democrat would increase policy
uncertainty.

Andrew Doherty. AssureInvest

This article is provided as general information only and should not be construed as personal financial advice.

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The data, information and research commentary in this document (“Information”) may be derived from information obtained from other parties which cannot be verified by AssureInvest and therefore is not guaranteed to be complete or accurate, and AssureInvest accepts no liability for errors or omissions.

The Information constitutes only general advice. In preparing this document, AssureInvest did not take into account your particular goals and objectives, anticipated resources, current situation or attitudes. Before making any investment decisions you should review the product disclosure document of the relevant product and consult a securities adviser. Past performance is no guarantee of future performance. This document is not intended for publication outside of Australia.

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